Bill Miller Letters Archive

1991 Q4 – Market Commentary

The stock market surged during December, propelled higher by the dramatic cut in the discount rate (the rate member banks pay to borrow reserves from the Federal Reserve) announced on December 20.

The market bottomed on December 10 at 2863, and began a desultory rise into the “triple witching” option expiration on December 20. Including the two days before the lift-off occasioned by the discount rate cut, the market rose 10 straight days before stalling at the present 3200 level. The rally was very impressive, encompassing large and small companies, and bonds as well as stocks. Like most powerful advances, it came when sentiment was negative and the press was (and is) full of stories of economic woe. It was reminiscent of the beginning of the 1991 bull market, which exploded while the world’s attention was riveted on the Persian Gulf.

December’s rally capped an exceptional year for equity investors generally and fund shareholders in particular.

The cut in the discount rate to 3.5% from 4.5% was important for two unrelated reasons: it signaled the determination of the Federal Reserve to use monetary policy aggressively to stimulate economic growth and it initiated the most important financial event of 1991 – the collapse of short-term interest rates.

Until December 20, the Fed had pursued a policy of gradualism, lowering rates slowly as evidence of economic weakness and low inflation accumulated. Many in the market feared that this recession would prove the economic equivalent of the Viet Nam war: it would drag on interminably as the authorities pursued a policy of gradual escalation, instead of decisively using the resources available to reignite the economy. The Fed has now demonstrated a willingness to move aggressively, which reduces (but does not eliminate) the chances that monetary policy will be unsuccessful in stimulating growth.

The market’s explosive rise, though, has little to do with a newfound confidence that the recession will soon end and earnings growth will resume. It reflects much more a re- pricing of existing earnings and dividends than renewed expectations of future growth. The sharp fall in short-term rates that followed the Fed’s action reduced the rates of return available on money market instruments and bank CDs (called “certificates of depreciation” by one disgruntled holder) that compete for funds with stocks and bonds. The result was that the relative returns of equities were thereby increased, and prices

quickly moved up to reflect the new equilibrium. This spring, stock yields were only 50% of money market yields. Now, after an 11% rally, they are 65% of the yield on money funds.

The perhaps counter-intuitive result is that stocks are now more attractive than they were six months ago, even though their prices are higher. Usually, stocks get less attractive as their prices rise, because the future rate of return is thereby reduced, other things being equal. But other things are not now equal. The sudden collapse of short-term interest rates to levels not seen in a generation has dramatically altered the investment landscape in ways that we believe have only begun to be appreciated.

The level of interest rates at various maturities, what economists refer to as the term structure of interest rates, is a complex amalgam of credit demand and money supply. In the 1970s the money supply expanded rapidly to accommodate the fourfold increase in the price of the world’s most important commodity, oil. The result was rapid inflation and an investment era where hard assets predominated. In response to inflation, monetary authorities reduced money growth. In response to higher prices, increased supplies of industrial and farm commodities were produced. The disinflationary 1980s were born.

The 1980s were also a period of high consumption and debt creation. Consumption as a percent of GNP rose from 61% to 67%, while debt grew from about 135% of GNP to 190% by the end of the decade. Debt growth financed consumption, LBO’s, and the S&L debacle: relatively little debt financed productive additions to the U.S capital base. Over 50% of the growth of assets in our banking system in the second half of the decade went to finance real estate construction. Although it fattened the GNP statistics, much of that construction was uneconomic, as the pileup of bad loans on bank balance sheets attests.

The source of the consumption boom was demographic. The baby boom generation born between 1946 and 1964 entered its prime consumption years during the 1980s. As they entered the work force and began to form households, spending for cars, houses, home furnishings and appliances soared. Demographics, tax cuts, the ability to deduct consumer interest payments and an ethos of prosperity led to the free-spending, debt- driven decade just ended.

The 1980s were also a period of monetary restraint amidst strong demand for credit. Real interest rates stayed high, even as nominal interest rates fell. Individuals could earn high real rates in bank CDs and money markets without extending maturities and taking risk. They did just that: equities as a percent of household assets fell even as stock prices rose, and money piled up in short-term instruments. That environment has now changed.

The baby boomers have begun to enter their savings and investing years, the U.S. population is aging and the balance sheets of consumers remain leveraged even after nearly a year of paying down debt. Taxes at the state and local level continue to rise, as do health care costs, while wages are stagnant. Consumer spending should remain

subdued in comparison with the 1980s for most of the balance of the decade. Neither corporations nor the government want more debt, further restraining the demand for credit. Despite sharp declines in interest rates, the monetary base grows slowly, reflecting an aversion to credit creation.

We believe the 1990s will be characterized by very low short-term rates relative to the experience of the past 20 years. Long-term rates could also decline further as credit demand remains low and individuals readjust portfolios by extending maturities to capture real returns. The experience of the past twenty years where the optimal place for many investors was the short end of the yield curve, is an anomaly in financial history. The result of this anomaly has been that $3.5 trillion of assets is invested in short-term maturities compared to less than $400 billion total government debt outstanding with maturities of 10 years of more. The amount of liquid assets at the short end is greater than the total value of the S&P 500, which is about $2.8 trillion!

Periods of low inflation and slow economic growth have historically been excellent periods to own stocks. None of those prior periods had been preceded by the asset imbalance described above. The implications are obviously very bullish, and we wrote about the potential of this great portfolio shift in our last shareholders’ letter. December is normally a weak month for flows into equity funds; this past month appears to have been a record as investors accelerated the restructuring of their portfolios in response to falling short-term rates. The January 13 issue of Barron’s reports that one equity fund group saw assets increase by $2 billion, or 17%, in December alone. The numbers would have been considerably higher, but the phone lines were jammed for days.

Some analysts have opined that such activity is fundamentally unhealthy, reflects speculative enthusiasm, and heralds a market blow-off and collapse, as in 1987. We disagree. Long time shareholders may recall our consternation and concern in 1987 as the market moved higher without, in our opinion, fundamental foundation.

In 1987, stocks had been climbing for three years without even a 5% correction. More importantly, the Fed had been aggressively raising interest rates to slow an accelerating economy. Each increase in rates made stocks less attractive, yet they continued to advance. By September, money market yields were almost 3x those available in stocks, and long bonds yielded almost 4x what stocks did. To be as expensive on the latter basis, today’s Dow would have to be well over 4000.

We believe the rush to own equities represents a rational response to a changed environment, not speculative enthusiasm or an altered attitude toward risk. Equities as a percent of household assets are hovering near all time lows, and alternative investments are not attractive. About 75% of family net worth is in housing, and of the remaining 25%, 75% of that is in short-term instruments. Individuals need to increase their exposure to equities, and are doing so. As we indicated in our last letter, we believe this shift will be important and long-lasting.

Your fund has reduced its cash positions and increased its equity weighting. We also have nearly 11% in intermediate and long-term bonds, which provided us nice capital gains in 1991. After the sharp advance of the past month, it would not be surprising if the market pulled back and consolidated. If it does so, the draw-down of our cash and bond positions will accelerate.

The year ahead will no doubt contain its share of surprises and the market will respond, as is its wont, to the news of the day. Sell-offs and corrections, coupled with depressing economic or political events, will be part of the landscape in the coming year. We are optimistic, though, about the returns available in stocks compared to those achievable in other investments, and look forward to a good year in 1992.

As always, we appreciate your support and welcome your comments.